Why I'm skeptical about Motilal Oswal MF's Nifty Microcap Index Fund

Motilal Oswal's Microcap Index Fund is an audacious move. Microcap and that too passive! Let's understand it in detail.

Microcap means stocks below the top 500 in size. The Nifty Microcap 250 tracks such companies. They have an average daily volume of just Rs 5 crore. This used to be the playground of Portfolio Management Service (PMS) managers, not mutual funds. With this launch, MFs are taking back this lost ground. Historically, the risk is higher in such companies and so is the return.

But running a passive product in this space is really pushing the limits. Why? First of all, a much higher share of the microcap index gets churned every 6 months - because smaller companies fail more often and new ones take their place. This forces index funds to rebalance and in an illiquid market, this is tough. Second, liquidity! Microcap stocks don't have large free floats and daily volumes. Sometimes the free float is illusory - the promoter only controls it. Third, Sebi has placed a 2% limit on tracking error - this means Motilal cannot afford to slip up.

I'm normally a proponent of passive investing. But in the mid and small cap space, active funds still outperform. I expect, this is even more pronounced in the micro cap space because various informational and analytical arbitrages exist. So I'm very skeptical about this fund. But if they do pull it off, it'll be quite a landmark. We've looked at this fund from multiple angles in this story by Satya Sontanam , please do read.

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